Using Volatility Analysis to predict Stock Market Crashes
"Technical analysis is not exact science" - you will find it in many references and this is correct. However, when it comes to the stock market trading we may say that nothing is an exact science and nothing guarantees future performance. Now matter what you use, either fundamental or technical analysis, there is never going to be 100% guarantee that future market or a stock's trend will perform as your predicted. All predictions are based on the analysis of the past. A fundamental analyst compares past trends to the past fundamental data by assuming that similar fundamental data in the future would lead to similar trend behavior. The same is done in technical analysis. In our case we attempted to take a look back in the past at market volatility data and compare it to market trend's changes in the past.
The one may assume that pattern between changes in volatility and changes in a price trend noted in the past would be the same in the future. However, "technical analysis is not an exact science" and if you make a decision to use this study's results in your own technical analysis you have to understand that you are doing it at your own risk. Also, you have to understand that this study is done on one index only. While principles of volatility/trend pattern mentioned below may remain similar, the numbers stated below will be different for other market indexes and other stocks.
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The goal of the following study was to confirm one of the postulates of technical analysis that volatility is higher during down-trend as traders are less confident in the future and volatility is lower during up-trend when traders are more confident in their investments. Also, we attempted to find a pattern that may helps to predict stock market recessions, crashes and long-term down-trend. This study is based on the analysis of volatility on the daily charts (1-bar = 1 day) of the S&P 500 index.
We have selected the S&P 500 index because it reflects the stock market overall sentiment and by many analysts this index is considered to be much better gauge of the U.S. economy then DJI and other market indexes. Second point in the favor of the S&P 500 over stocks is that it allows us to track the history back to early 1980th. Plus we may disregard elements of fundamental analysis (which could be essential when a stock's trend reversals are analyzed) as it is already done by the Standards & Poors - the company that maintain the constituents of the S&P 500 index and calculates this index.
In our research we used Absolute ATR (ATR%) to evaluate the volatility. The Average True Range is well known in technical analysis as a perfect tool to evaluate volatility of a security. Choice was passed to Absolute ATR as it allows tracking the volatility in absolute values (in percent) which provide an ability of comparing volatility changes during different periods in history disregarding the price at which an analyzed instrument was traded. Such, in 1980th the S&P 500 was traded below $300 and in 2014 it was traded above $1,800 and Absolute Average True Range indicators lets us to compare volatility of this two periods in history.
We tested number of different settings starting daily charts (1 bar = 1 day) up to the weekly charts (1 bar = 5 trading days) with different ATR% bar period setting and we stopped our choice on the 14-day bar period for Average True Range because it reduces the spikes by keeping the lag relatively small. You will be able to find a chart setting which may predict the possibility of a stock market crash better (especially if you go to higher than 1-day charts), yet we kept our choice it because it will let you to verify our study results on charts easily and it is also mentioned in many resources as recommended ATR setting.
NOTE: You should know that whenever i this article we refer to the volatility we refer to the 14-day Absolute ATR applied to the S&P 500 index.
Our study is divided in four parts. In the first part we show you all occurrences of high volatility in the past. In the second part we discuss the volatility during the long-term up-trends. In the third summary part we gathered the main points that should be taken into the consideration when volatility is used in technical analysis of a long-term market trend.
Periods of High Volatility
In this part you will see S&P 500 charts of the periods of high volatility from the time of this study was performed (May of 2014) back to the early 1980th. As was already mentioned above, 14-day ATR% was used. Absolute ATR values at and above 2% were considered as indication of high volatility trading. Thus, in the periods of high volatility, we had in average 2% and higher price movements within 14 consecutive trading sessions.
NOTE: Whenever we refer to high volatility in this study we are referring to 14-day Absolute ATR readings at and above 2%. Whenever we refer to low volatility in this study, we refer to 14-day Absolute ATR readings below 2%.
Correction in August 2011
Chart #1: S&P 500 index in 2011.
Maximum volatility level was at 3.7%.
The S&P 500 index lost around 18% in just 2 weeks.
The high volatility was recorded when S&P 500 already lost around 10%.
The next three months the index was moving near the resistance level.
High volatility trading continued to the end of 2011.
Correction in May 2010
Chart #2: S&P 500 index in 2010.
During this correction on May 6 of 2010, as the result of computer/human entry (order was placed with extra zeros) on the Nasdaq Exchange, the S&P 500 index lost more than 8% within one trading session. This strong 1-day crash was the main reasons of high volatility readings and exactly on that day the 14-day ATR% broke 2% volatility level. If not this error on the Nasdaq Exchange, most likely the ATR% would remain below 2%.
Maximum volatility ATR(14) level was at 3.3%.
The S&P 500 lost around 16% during this correction.
After the high volatility was recorded, S&P 500 lost around 9%.
High volatility trading continued to the end of 2011.
Stock market Crash in 2008
This stock market crash is known in history as the "Housing Market Bubble". It hit strongly big financial institutions and big auto-makers.
Chart #3: S&P 500 index in the beginning of 2008.
Actually, the first high volatility readings were recorded in August of 2007 when Absolute ATR was above 2% level for period of 2 weeks.
It is all started in January of 2008 when the S&P 500 dropped about 12% from the top into the first deep correction and when high volatility was reordered again.
The highest volatility level was around 2.7%.
For 4 months (until April 2008) the market remained highly volatile.
Chart #4: S&P 500 index chart during the 2008 stock market crash.
Third time the ATR%(14) claimed above 2% in September of 2008 when the stock market (S&P 500) started its crash.
Maximum volatility ATR(14) level was at 8.7%.
From the moment when the high volatility level was spotted (September 2008) the S&P 500 lost around 45%.
The high volatility was recorded when S&P 500 already lost around 10%.
The S&P 500 index remain volatile at the beginning of the recovery up to June of 2009.
Overall, the high volatility was noted far before the stock market crash - when the stock market went into deep correction in January 2008. After the bounce up the market (S&P 500 index) continued sliding down on low volatility until it finally crashed in September 2008. The market crash was quite strong and high volatility was still seen during the several months at the beginning of the recovery as well.
Stock market Crash in 2000 - 2003
This stock market crash is known in the history as "Internet Bubble".
Chart #5: S&P 500 index chart in 2000 just before the crash.
First signs of high volatility was recorded on the S&P 500 index in March-April of 2000. At that time the 14-day Average True Range reached 3.1%.
Second time high volatility was seen from October 2000 to January 2001 when 14-day ATR% hit 2.5% at its highest point.
The same as in 2008, several periods of high volatility were recorder within 6-month period before the crash itself.
Chart #6: S&P 500 index chart in 2001 - beginning of the crash.
Another two periods of high volatility were recorded when the S&P 500 index was already in the recession.
In March-April of 2001 the 14-day ATR% reached 2.9%.
In September 2001, following the 9/11 terrorist attack, the volatility reached 3.1%.
Within 1 year period (from March 2000 to March 2001) the 14-day ATR was running four times over 2% level.
Chart #7: The S&P 500 index chart in 2002 - the final stage of the market crash.
The last time during the 2000-2003 recession the high volatility was recorded in the period from June until November 2002 when the stock market literally crashed.
At that period the highest volatility was seen at 4.2% level.
Overall, 2000-2003 recession was prolonged in time and during this recession we had strong bounces up. During this recession we had periods of high volatility (ATR > 2%) as well as periods of low volatility (ATR < 2%).
Correction in August 1998
Chart #8: The S&P 500 index chart of the deep correction in 1998.
It is difficult to call this down-move as a stock market crash as S&P 500 index did not even loss 20% during this decline. Yet, it was quite strong correction.
First time high volatility was seen in the beginning of August 1998 when the S&P 500 already lost about 8%.
Highest 3.6% volatility level was reached near the bottom of this correction in September 1998.
During this correction the S&P 500 lost around 19% from the top.
Stock Market Crash in 1997
Chart #9: The S&P 500 index chart in 1997.
It is difficult to call a market crash, yet in one trading session the S&P 500 lost more than 8% and this is was the main factor of the increase in volatility.
This is was mainly one day crash and right after the crash the market resumed its bullish trend.
The volatility failed to spot this crash because, as was already mentioned about, it was 1-day crash only.
Correction in August 1990
Chart #10: The S&P 500 index chart at the end of 1990.
It was a deep correction when the S&P 500 index lost around 18%.
The high volatility levels were recorded at the bottom of this correction.
2.3% was the highest volatility level.
Stock Market Crash in 1987
This stock market crash is known in the history as "Black Monday"
Chart #11: S&P 500 index chart of the "Black Monday" - market crash in 1987.
The same as prior to 2000 crash and prior to 2008 crash, first high volatility readings were seen within 6 months before actual crash occurred.
In April 1987 Volatility (14-day ATR) reach 2.2%.
Just a couple of days before the "Black Monday" the volatility run above 2% level.
7.1% was the highest recorded volatility level.
Low Volatility levels and long-term Uptrend
As a result of this study, it could be said that 14-day ATR% readings below 2% level could be considered as a sign of long term up-trend. Thus, low volatility was seen during the following Bullish periods (in the brackets you will see approximate S&P 500 index values at the beginning and end of these periods respectfully):
About 55% up-trend from December 2011 until June 2014 when this study was done (1230 - 1910)
About 10% up-trend from August 2010 to December 2010 (1090 - 1200)
About 21% up-trend from June 2009 to April 2010 (930 - 1130)
About 72% up-Trend from April 2003 to August 2007 (850 - 1470)
About 26% up-trend from October 1998 to February 2000 (1100 - 1390)
About 21% up-trend from November 1997 to 1998 to August 1998 (930 - 1130)
About 200% up-trend from October 1990 to 1998 to October 1997 (310 - 950)
About 23% up-trend from January 1988 to 1998 to August 1990 (260 - 320)
Total buy and hold S&P 500 index growth since 1987 crash until June 2014 (when this study was done) would be around 630%. On the other hand, compound profit from the caught by low volatility up-trends listed above would be around 1,600%. However, this number does not take into account periods of low volatility during the 2000-2003 and 2008 stock market crashes when the volatility level remained below 2% and S&P 500 index was in decline. In order to avoid these periods of low volatility during long-term down-trends, a trader or a technical analyst has to use other additional technical indicators or to implement an additional volatility rule which would state that if after recorded high volatility readings , volatility drops to low levels, however the market continues to decline it, could be a signal confirming a stock market crash and long-term bullish position should not be initiated.
You have to understand that this study was done on the S&P 500 index and the numbers (14-day Absolute ATR and 2% critical volatility level) mentioned in this study refer to the S&P 500 index only. If you analyze the DJI, Russell 2000, Nasdaq 100 or other indexes, you should perform research and find the volatility setting which would fit the indexes you analyze. As well, the volatility numbers mentioned here should not be applied to stocks. Each stock moves with different volatility.
Also, you should remember, that the goal of this study was to spot pattern in volatility that would help us to identify stock market crashes. If you want to use volatility in spotting market corrections, different volatility setting should be used.
As the result of our research we may say that for the S&P 500 index (pros and in green, cons are in red and statements just in black):
Volatility could be used to identify stock market crashes, long-term trends and recessions.
Based on the analysis of the past 30 years, the S&P 500 index and 14-day Absolute ATR with 2% critical volatility level could be use to spot long-term down-trends and stock market crashes.
Most of the time, high volatility (14-day Absolute ATR is at or above 2%) is associated with bearish sentiment and low volatility (14-day Absolute ATR is below 2%) is associated with bullish sentiment. The only exception was seen in the beginning of the recoveries after strong crash.
The setting above, may also catch deep correction and in this case high volatility readings could be seen at the bottom of a correction. Since the 2% level on the 14-day ATR% also could be seen at the bottom of a deep correction, an additional analysis could be required to recognize a correction from a market crash.
If high volatility above 2% is associated with long-term down-trends, volatility above 4% is indication of a market crash.
In all cases of stock market crashes, before a crash started, several high volatility periods were noted within 6-month time frame. Furthermore, if mentioned above volatility setting spotted a deep correction and within 6 months after that we see volatility rising back to high levels, it could be a confirmation of coming recession. At this points the odds of coming market crash are high.
If we spotted the high volatility, however, prior to this event no high volatility were noted for a long time (more than 6 month) then the odds are high that this is just a deep correction.
There could be periods of low volatility within an established long-term down-trend (as an example see 2000 - 2003 charts above). A trader should be able to recognize the long-term downtrend periods and ignore these low volatility signals. The following could be recommended:
it is long-term bearish sign when after high volatility readings (signal of bearish market) the market continues to decline on low volatility for more than a month. Such low volatility should be ignored as it occurs within long-term bearish trend;
other technical indicators could be used - as an example long-term moving averages could be used to to define a long-term trend within which low volatility signals should be ignored.
Because high volatility could be spotted at the bottoms of big corrections, it could be recommended not to base a trading decision "to sell short" solely on volatility.
The long-term trend volatility analysis could be more suitable for conservative long term traders who prefer either bullish or cash position.
Recovery from a stock market crashes or a long-term down-trends may also start on high volatility and high volatility could be seen during the first several months of a recovery. Furthermore, the volatility analysis may be not the best tool to recognize beginning of a long-term up-trend. It could be recommended to consider using additional technical indicators to spot bottoms of stock market crashes when a trader is looking for a better entry points of a bullish long-term position.
It could be challenging and almost impossible to use volatility to predict sudden crashes caused by non market related events, such as terrorist attack and etc.
It could be also recommended to use additional technical indicators to recognize and confirm long-term down-trend and market crashes. A price trend is described by change in price (price movement), volume traded during this change in price and volatility of the price changes. Furthermore it is recommended to analyze all three parameters - price, volume and volatility.
It is also, recommended to monitor economic and political events to understand the source of a crash and or a deep correction. It may help in understanding whether deep correction recognized by high volatility may grow into a stock market crash. Such, in May 2010 crash was caused by a human/computer error and deep correction in January 2008 was caused by the possibility of bankruptcy of big financial institution (Fannie Mae and etc). In the first case up-trend was resumed shortly and in the second case the financial/housing crisis turned into the stock market crash.
Several additional points noted during our research and not related analysis of long-term trends:
Due to the spikes in price it could be very difficult to use volatility analysis to recognize mid- and short-term trends on intraday charts.
We used 1-day charts (1 bar = 1 day), yet, better long-term analysis results cold be achieved by using higher timeframes - charts with 2-day bars, 3-day bars and etc.
Example Of Long-Term Trading System
This is just an example of conservative long-term trading system that uses volatility to avoid trading during stock market crashes, long-term down-trends and recessions. In this example a hypothetical trader does not sell short - he only buys long or remain in cash. This system is for the S&P 500 index and when we refer to volatility we refer to 14-day ATR% applied to the S&P 500 index. Under high volatility levels we understand 14-day ATR% readings is at or above 2%. Respectfully, when we refer in this system to low volatility levels we are referring to the 14-day ATR readings below 2%
Rule #1: When volatility on the S&P 500 rises to high levels (at or above 2%), check when the last time high volatility on this index was recorded:
If high volatility levels were also seen within the past six months, then exit long trade and remain in cash - the odds are high that this is long-term down trend.
If previous high volatility trading was seen more than six month ago - the odds are good that this is just a deep correction. Still, depending on when it was and personal risk tolerance you may exit long trade or remain in long trade. As an example, if the last high volatility was seen two years ago, the odds are high that this is a deep correction and you may remain in long position. If it occurred eight months ago, a more conservative trader may exit a long position into a cash as the odds will be only slightly in the favor of deep correction over a recession.
Rule #2: When volatility on the S&P 500 rises to high levels (at or above 2%), check the news to understand the main cause of this decline and what affect on the market it may have.
Rule #3: 4% and higher volatility should be considered as a crash volatility. No any long position should be open by that time.
Rule #4: When volatility on the S&P 500 drops to the low levels (below 2%) after being at high levels (at or above 2%) you may consider entering a long position:
If it happened after crash volatility levels (maximum ATR% was above 4%) then the odds are high that this is recovery.
If maximum volatile was below 4% and this was after the first volatility occurrence (see rule #1.b), go Long as the odds are good that this was just a deep correction.
If maximum volatile was below 4% and this was not after the first volatility occurrence (see rule #1.a), be cautious and check other long-term indicators. You still may go Long, however, if the S&P 500 continues to decline on low volatility for a month or longer, go to cash as the odds are good that this is just temporary slow down within a long-term down-trend.
System's disclaimer: One more time we would like to remind that the simple trading system described above is just an example. If you want to use this system you may use it at your own risk. If you want to adopt this system to other indexes or stocks it could be highly recommended scanning the history and finding appropriate volatility setting (ATR% bar period and critical volatility level)
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